When The Cloud Disappears, Look Out Above!

Rudolph-Riad Younes, Co-Founder and Head of International Equities, R Squared Capital Management and Co-Portfolio Manager of the RSQ International Equity Fund

Rudolph-Riad Younes: Before we invest in the international equity markets, we look at the global picture. Currently, there are eight key pieces to the global puzzle that we are attentive to as we make our stock selections.

The first point is that we have profit margins that are at double the historic average in the United States. Our analysis attributes it mainly to government deficit spending, ironically its unintended consequence is corporate welfare. Whenever fiscal deficit spending disappears, so will half of corporate profit margins, in our opinion.

Second, we expect global growth to remain subpar for the foreseeable future. Sovereign Debt-to-GDP in the developed world remains alarmingly high at above 110%. No meaningful de-leveraging has occurred in this down cycle. The debt mainly shifted from the private to the public sector.

Third, commodities are at the beginning of a multi-year downward correction. Most major commodities appreciated about five-fold or more since China's entry into the World Trade Organization (WTO) in 2001-2002. This demand shock from China generated a belated supply response. A combination of decreasing demand today from China and increasing supply will force a severe retracement in these commodities prices. For example, if we look at the long-term forward contract for the West Texas Intermediate Oil, we find that the market is at $75 versus today’s price of $97. And we expect a similar deflation in other commodities prices.

Fourth, China's failure to wean off its addiction to fixed asset investments has been blatantly apparent in the last two years. Despite its acknowledgment that fixed asset investments are too high and consumption is too low as a percentage of GDP, the Chinese government failed to steer these ratios in the right direction. As a matter of fact, these ratios have gone ballistic in the wrong direction -- an omen that the adjustment and the balancing of the economy are not likely to occur smoothly.

Fifth, given this outlook, we are bearish on most emerging countries or those developed countries that are rich in commodities like Australia and Canada. Over many years, these countries have benefited from rising commodities prices and foreign capital flow seeking growth and yield. Now as the prices of commodities have started to correct downward and foreign capital has started to exit, we expect many emerging markets to enter a long and harsh winter. That is the usual correction needed to redress a long binge of excesses and misplaced confidence.

Sixth, Europe is the brightest spot in our investment universe, especially the financial sector, which was decimated mainly due to fears regarding the fault lines in the Europe project. We believe great strides have been finally made to correct them, and many more will be needed and will be taken in the coming years. European banks, especially those in the Euro area, still trade at or below tangible book. We believe they represent a unique opportunity of substantial appreciation in a world of 0% interest rates and over-valued assets.

Seventh, Japan's efforts to create an inflation of 2% and to revitalize its economic growth, if successful, will make the recent rally very sustainable. Japan surely needs to address its mushrooming public debt, which means that they need to have GDP growth that is much higher than the coupon on the Japanese government bond in order to facilitate the decline of the government debt-to-GDP ratio without the need for draconian fiscal austerity measures.

Finally, while in the recent past, global players with high emerging market exposure have been handsomely rewarded, today we expect companies whose activities are concentrated in the developed world, especially Europe and the U.S., will outperform their global counterparts.

Wally Forbes: Did you say that Japan is one of the vulnerable areas?

Younes: Not really. It's more like we are cautiously optimistic because Japan has a very high debt-to-GDP ratio -- especially the government debt. In Japan, you have 0% interest rate, and you have 0% economic growth, so there is no room to have the debt decline without resorting to austerity measures.

But if Japan were to have 3% to 4% nominal GDP growth while the average coupon on its debt is like 0.5% to 1%, then debt relative to GDP can decline by 2 to 3% per year. Hence, over ten years that will make the ratio decline by almost 30% to 40% while having just a primary balanced budget--without any need for a primary surplus.

Forbes: So, it's cautiously optimistic as you say rather than as positive as both the U.S. and Europe are at this moment?

Younes: Correct,because we don’t know if it’s going to work. If we look at Lloyds Banking Group (NYSE: LYG) and Bank of Ireland (NYSE: IRE), they both have kind of a similar story. The crisis has been a boon to the surviving banks because the sector has dramatically consolidated. Let’s start with Lloyds. In the U.K., Lloyds has a market share of 25% in the deposit market. It's a huge, dominant position. The industry has become very oligopolistic. And Lloyds is the strongest bank today. It's the bank that has cleaned its balance sheet the earliest and we expect the government to be out as a shareholder in the near to medium term. We also expect them to start paying a dividend over the next couple of quarters.